ECNM611 Budget Constraint

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ECNM 611

Mr. Khumalo J.Mr. Khumalo J.Email: [email protected] hour: By appointment

Office: Room number 131, 1st floorContact: 082 590 2827 (9am-4pm)

Core TextsCore TextsCore TextsCore TextsCore TextsCore TextsCore TextsCore Texts

§ Varian H. Intermediate Microeconomics: A modern approach (6th/7th/8th edition), W.W. Norton & Co, 2003/2006/2010 Norton & Co, 2003/2006/2010

§ Complementary Texts (Refer to your Course Outline footnote 1

Lecture StructureLecture StructureLecture StructureLecture StructureLecture StructureLecture StructureLecture StructureLecture Structure

1. Budget Constraint2. Properties of budget set3. Changes in Budget Line4. Taxes, Subsidies, and Rationing

Budget ConstraintBudget ConstraintBudget ConstraintBudget ConstraintBudget ConstraintBudget ConstraintBudget ConstraintBudget Constraint

Consumer theory: consumers choose the best bundles of goods they can afford.

üThis is virtually the entire theory in üThis is virtually the entire theory in a nutshell

üBut this theory has many surprising consequences


Two parts to theory

ü"can afford" - budget constraint ü"best" - according to consumers' preferences


üThe definition of "best" depends on the consumer preferences.

üBudget constraint determines what a consumer can affordwhat a consumer can afford


Consumption bundle ü - how much of each good is consumed

ü - prices of the two goods ),( pp

),( 21 xx

ü - prices of the two goods üm - money the consumer has to spend

),( 21 pp


üConsumption bundle: (Xl, X2) -two numbers that tell us how much the consumer is choosing to consume of good 1 and how consume of good 1 and how much the consumer is choosing to consume of good 2.


budget constraint:üWhere is spending on good 1 and is spending on good 2. The budget constraint tells us that

mxpxp ≤+ 2211

11xp22xp

The budget constraint tells us that total spending cannot exceed m.

üAffordable consumption bundles are those that don't cost any more than m.


üAll that satisfy this constraint make up the “budget set” of the consumer

üBudget set is a set of affordable

),( 21 xx

üBudget set is a set of affordable consumption bundles at prices

ü and income m.),( 21 pp


üBudget Set (Shaded)

Properties of the Budget SetProperties of the Budget SetProperties of the Budget SetProperties of the Budget SetProperties of the Budget SetProperties of the Budget SetProperties of the Budget SetProperties of the Budget Set

üBudget line is the set of bundles that cost exactly m

üFrom make the subject of the formula

mxpxp =+ 2211 2xthe subject of the formula

üYou get

üWhere is the slope the BL

12

1

22 x

pp

pm

x −=

2

1

pp

−


üHow to draw the BL given P’s & m1.Calculate how much of good 2 will be bought if all m spent on good 2( ) m

x =good 2( ) 2.Calculate how much of good 1 will be bought if all income spent on goo1( )

22 p

mx =

11 p

mx =


üThe slope measures the rate at which the market is willing to substitute good 1 for good 2

üMeasures the opportunity cost of üMeasures the opportunity cost of good 1

Changes in the Budget LineChanges in the Budget LineChanges in the Budget LineChanges in the Budget LineChanges in the Budget LineChanges in the Budget LineChanges in the Budget LineChanges in the Budget Line

üIncreasing m makes parallel shift out.

üChange in income affects only the intercept & not the slope.intercept & not the slope.

üConsider fig 2.2 below

Changes in incomeChanges in incomeChanges in incomeChanges in incomeChanges in incomeChanges in incomeChanges in incomeChanges in income

Figure 2.2 Increasing income

Changes in incomeChanges in incomeChanges in incomeChanges in incomeChanges in incomeChanges in incomeChanges in incomeChanges in income

üDraw the figure/diagram that depicts a decline in income

üDRAW NOWüDRAW NOW

Changes in pricesChanges in pricesChanges in pricesChanges in pricesChanges in pricesChanges in pricesChanges in pricesChanges in prices

üIncreasing PI makes budget line steeper. See Figure 2.3.

üIncreasing P2 makes budget line flatter. flatter.

üJust see how intercepts change.


Figure 2.3 Increasing price


üMultiplying all prices by t is just like dividing income by t

üMultiplying all prices and income by t doesn't change budget line by t doesn't change budget line

Taxes, Subsidies & RationingTaxes, Subsidies & RationingTaxes, Subsidies & RationingTaxes, Subsidies & RationingTaxes, Subsidies & RationingTaxes, Subsidies & RationingTaxes, Subsidies & RationingTaxes, Subsidies & Rationing

Economic policy often uses tools that affect a consumer's BC.

üQuantity tax: the consumer has to pay a certain amount to the to pay a certain amount to the government for each unit of the good purchased (e.g. fuel tax)

üp' =p+t


üValue tax ('ad valorem' tax): tax on the value (the price) of a good, rather than the quantity purchased of a good (e.g. VAT) of a good (e.g. VAT)

üp' = (1 + r)p üi.e. the consumer has to pay p to the supplier and –rp government for each unit of the good.


üQuantity subsidy: the govt gives an amount to the consumer that depends on the amount of the good purchased good purchased

üp' =p- s


üAd valorem subsidy: subsidy based on the price of the good being subsidized p'=(1-σ)p

üSubsidy is just the opposite of a tax.


üDraw up a diagram that shows rationing


üPRACTICE THE REVIEW QUESTIONS ON CHAPTER 2 ATTACHED HERE

THANK YOU

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ECNM611 Budget Constraint